Bob Carlson for Investing Daily writes: Retirees often are blindsided by high tax bills. Retirees are the targets of many of tax increases, though they aren’t explicitly named. Instead, Congress enacts stealth taxes that quietly drain cash from retirees.
Fortunately, you can fight back. Retirees have more control over their tax burden and more flexibility than most taxpayers, especially when you start planning before retirement. Even if you wait, there still are steps to take.
The key to keeping your tax burden low is to reduce your adjusted gross income. That’s the number at the bottom of the first page of the standard Form 1040. AGI is critical, because most of the stealth taxes are based on it instead of taxable income, which is calculated on the second page of the 1040. Taxable income is lower than AGI because of the personal exemptions and either the standard deduction or itemized deductions. Even those are reduced or phased out if your AGI is too high.
The stealth taxes are numerous: phaseouts of personal exemptions and itemized expenses, the 3.8% tax on net investment income, inclusion of some Social Security benefits in gross income, the Medicare surtax, and more. You beat these stealth taxes primarily by reducing AGI. When you can’t reduce AGI, you still reduce the overall tax burden by controlling the types of income you receive.
Retirees often can choose how and when they receive income. By carefully paying attention to the sources of income and the amount of AGI, they have more control over their tax burden. In fact, you can almost determine the tax rate you want to pay. Some planners refer to this as tax bracket management. In this visit, you’ll learn how to keep your tax bracket as low as possible year after year.
Diversify income sources. The key to tax bracket management is tax diversification. Tax diversification recognizes that different types of income are taxed differently. The tax law and your situation can change, so you don’t want only one type of income or tax break. During the working years, most income tends to be ordinary income, whether it is salary or business profits. But in retirement you often can diversify income sources.
Tax diversification is achieved by having your investments in different types of accounts: traditional IRAs and 401(k)s, Roth IRAs and 401(k)s, taxable accounts, annuities, and any others available to you. You’ll also have other sources of income, such as Social Security and perhaps some form of pension. Having different income sources allows you to use all the available strategies.
Reduce or convert traditional IRAs. One of the greatest obstacles to tax bracket management is having too much of your nest egg in traditional IRAs or 401(k)s. Most people don’t realize this until it is too late.
Traditional IRAs (and other forms of tax deferral) are great during the accumulation years. Yet, they create two problems during the distribution years. One problem is that all distributions are taxed as ordinary income, facing your highest tax rate. The other is that after age 70½, minimum distributions are required. As you age, the required distributions increase, and many people in their late 70s and beyond complain that the required distributions far exceed their cash needs and increase taxes.
There are a couple of strategies. One is to take IRA distributions before you need the money. Over time or in a lump sum take money out of the IRA, pay the taxes, and put the rest of the distribution in a taxable account. When you spend the principal in the future it won’t be taxed. You’ll also be able to invest the money so future income and gains receive favorable tax rates, as we’ll discuss.
The other strategy is to convert all or part of the traditional IRA to a Roth IRA. You pay taxes on the converted amount, but future distributions to you and your heirs are tax free.
Most people don’t want to prepay taxes. It goes against one of the longstanding principles of tax planning. But when taxes will be higher in the future, especially when you’ll be faced with an array of stealth taxes, paying taxes now can make sense. In 2010 favorable tax treatment was offered to those who converted traditional IRAs to Roth IRAs that year. The IRS recently reported the results. Conversions increased by nine times over the previous year. Among taxpayers with $1 million or more of income, more than 10% did conversions. That means the taxpayers who receive the most sophisticated advice decided paying taxes early was a good idea when it converted future ordinary income into tax-favored or tax-free income.
An advantage of a Roth IRA is that distributions from it, no matter how large, aren’t included in AGI. That is a big help in avoiding the stealth taxes triggered by higher AGI.
More details about who might benefit from reducing or converting traditional IRA are in my books, Personal Finance for Seniors for Dummies (with Eric Tyson) and The New Rules of Retirement.
Time IRA distributions and conversions. Consider more than immediate cash needs when deciding how much to distribute from a traditional IRA or 401(k) or how much to convert to a Roth IRA. Consider the rest of your tax picture. Increase distributions or conversions in a year when your tax rate is lower. Perhaps you have high deductible medical expenses, a business loss, earned less income, or have other factors that reduce your tax bill. That would be a good year to increase IRA distributions or conversions, because you’ll be in a lower tax bracket or have deductions to offset the taxes on the IRA transactions.
Delay Social Security. You need to consider a number of factors before deciding when to take Social Security, but income taxes are a reason to defer benefits. Social Security benefits are tax free or mostly tax free unless your AGI is above $44,000. Since delaying benefits increases your benefit, it also increases your potentially tax-advantaged income.
Seek tax-advantaged income. Your taxable accounts should seek tax-exempt income, qualified dividend income, and long-term capital gains. Investments that generate ordinary income, such as interest, should be in other types of accounts or annuities whenever possible. It also is wasteful to take short-term capital gains in taxable accounts without a compelling reason.
There’s a catch with tax-exempt interest. It generally is excluded from gross income and therefore AGI. But some of the stealth taxes, such as the Medicare premium surtax and the tax on Social Security benefits, use modified AGI. Modified AGI is regular AGI plus tax-exempt interest and foreign earned income that was excluded from income. So, if your AGI is near stealth tax thresholds, tax-exempt interest might not help.
Use tax-wise investment strategies. Taxable accounts need to be managed with both taxes and investment returns in mind, resulting in higher after-tax returns.
Loss harvesting is an important strategy. When investments decline below the purchase price, sell them and book the loss. In most cases you can buy them back after waiting more than 30 days or immediately buy another investment that isn’t substantially similar. The losses offset capital gains earned during the year. Losses that exceed your gains can be deducted up to $3,000 annually to reduce taxes on other income. When losses for the year exceed gains plus $3,000, you can carry the excess amount to future years to use in the same way.
You also want to avoid owning in your taxable accounts mutual funds that distribute a lot of their gains each year, forcing you to include them in gross income. Look for mutual funds with low turnover ratios or for tax-favored investments such as master limited partnerships.
Avoid selling investments at a gain if you held them for one year or less, unless there is a compelling nontax reason. You want to earn long-term capital gains instead of ordinary income or short-term gains.
Manage your tax bracket annually. When you have tax diversification and the other strategies in place, you are in position to manage your tax bracket, keeping it around 15% to 20% annually.
You’ll have a base automatic income from Social Security and perhaps some annuities and pensions. After age 70½ you’ll also have required minimum distributions from traditional IRAs and 401(k)s. Your taxable accounts might generate qualified dividends, tax-exempt interest, mutual fund distributions, and other income that’s outside your control.
But you have flexibility beyond that you can use to minimize your tax burden while meeting spending needs. You want to focus on keeping AGI as low as possible and minimizing ordinary income.
To meet spending needs that exceed the automatic income, carefully choose the sources. You might sell some assets in taxable accounts at long-term capital gains to raise cash. Or if AGI is too high for the year, consider Roth IRA distributions to avoid triggering a higher tax bracket or stealth taxes. In a year when AGI is low or you have deductions to offset ordinary income, consider taking extra distributions from traditional IRAs or annuities.
With tax diversification and tax bracket management, you can generate substantial cash flow each year while keeping your tax rate at 20% or even less. Many retirees avoid the higher ordinary income tax brackets despite substantial cash flow. You can avoid the stealth taxes and other burdens Congress aims at you.
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